IRS Steps Up Audits of U.S. Expatriates-Arbitrarily Denying FEIE to Civilian
Workers in Iraq and Afghanistan-PART I

The Internal Revenue Service has opened five
projects to find taxpayers who may be erroneously claiming the benefits of the
Internal Revenue Code Section 911 foreign earned income exclusion (FEIE).
However, according to U.S. Treasury inspectors, the IRS is doing a poor job
policing claims by American expatriates, and many violators are falling through
the cracks. But what they are not seeing, or at least admitting to, is the fact
that the IRS agents who are auditing the returns of U.S. expatriates claiming
the FEIE are clearly not familiar with the legislative intent of IRC Section 911
and the FEIE, how it actually works (or should work) and instead of blindly
following internal policies or directives to arbitrarily deny the FEIE to any
U.S. person who they think may have a U.S. abode based on information learned
through the examination process. This is because in order to qualify for the
FEIE or the special housing deduction or exclusion as described in IRC Section
911, in addition to meeting either the bonafide residence or the physical
presence test, the taxpayer must have a foreign tax home, and in 1978 (in an
effort to close perceived loopholes in the law and prevent abuses by U.S.
persons claiming that they were bonafide residents of foreign countries even
though they spent a significant portion of the year living with their spouses
and children in their home in the U.S. and clearly had substantial ties to the
U.S. and virtually none to a foreign country (especially if they lived on an
offshore oil rig), Congress enacted IRC Section 911(d)(3) stating that if a
person's abode is in the U.S. they could not be deemed to have a foreign tax
home and therefore did not qualify for Section 911. Note that the Code states
"if the person's abode IS" and does not say "if the person HAS an abode" in the
U.S., nor does it use the word domiciled, which although included in the
definition of abode in Black's Law Dictionary, can have an entirely different
definition for purposes of state income taxation as regards residency. In fact,
the word "abode" depends on the context in which it is used. In the cases cited
by the IRS in their Memorandum Number AM2009-003 it involves taxpayers claiming
the bonafide residence test although they spend half the year with their family
(spouse and children) in the U.S. as citing Lemay and Bujol. Clearlythis sets the ground for someone attempting to claim the BR test who spends
a substantial amount of time in the U.S. at the home where his spouse and
children live. However what about a single person who spends virtually all of
his or her time in the foreign country, although that person does own certain
assets located in the U.S.

The term "abode" as added by the 1978 Foreign
Earned Income Act is not defined by the Act; however in the House Ways & Means
Committee report gives an example of a person who lives in Michigan and works in
Canada, commuting daily and living with his family in Michigan. Again, an
example of how a person cannot claim to be a bonafide resident of a foreign
country when they spend a significant portion of their time (in the example
given it was every day) returning to their home (or "abode") in the U.S. In
fact, all case precedence seems to reflect a taxpayer who does not meet the
physical presence test requirements and sought to claim the he/she was a
bonafide resident of a foreign country.

So what about someone who relocates to a foreign
country, including Iraq or Afghanistan, and actually lives there for 18-24
months, making contacts with the local residents, helping the sick or wounded
civilians, etc. Merely because that person may own assets in the U.S. such as a
bank account, or residential real estate (which they may or may not rent) or if
they keep their driver's license for sake of convenience, does that mean that
this person's "abode" or place of residence is in the United States. I don't
think so. If you read IRC Section 911(c)(3) keeping in mind that it states that
a person who's abode is in the United States shall not have a foreign tax home,
I can't help but believe that this term "abode" when legislated by Congress, was
intended to have the meaning of a person's PRINCIPAL residence, where they spend
a significant portion of their time during the year, and was never intended to
be twisted or confused in a way that would deny a U.S. person the benefits of
the physical presence test even though they met all of the qualifying
conditions, except that they owned property in the U.S. or had a driver's
license or exercised their right to vote. Now this is not legal advice, it is
ONLY MY OPINION however I strongly feel that it should be considered when
determining if a person qualifies for benefits of Section 911, whether they are
preparing their tax return or disagreeing with the IRS should they seek to deny
the benefits of Section 911.

In an ongoing IRS examination of a U.S. taxpayer
(who we will refer to as Mr. X) who has contacted Tax Power, and is preparing to
take the IRS findings and adjustments to Tax Court, the details and development
of the tax return IRS examinations of his 2006 and 2007 tax returns, and the
proposed adjustments of the IRS, are absolutely incredible (which is why we have
asked this person to provide us with copies of all of the IRS notices and
correspondence, as well as the actual tax returns as filed). From what the
taxpayer has told us, I can't help but assume that this audit is part of the
"five projects" mentioned above, and that the examining agent is following
internal agency tax return audit guidelines based on IRS Memorandum Number
AM2009-003 (see Tax Power report discussing this at
http://www.tax-power.com/iraq_contractors.htm) without having any in depth
understanding of IRC Section 911 or the requirements thereof, including what is
a foreign tax home and exactly what is the definition of a "U.S. abode" for
purposes of Section 911. Note that in IRS Publication 54, the IRS states that if
the persons stay outside the U.S. is for more than 12 months, their tax home is
in the foreign country, and if a person's foreign assignment is expected to last
12 months or less, but is later extended beyond the 12 month period, then their
tax home is in the U.S. for the first year and outside the U.S. in the second
year. That is, of course, if they do not maintain an "abode" in the U.S., which
is not clearly defined in the Code, the Treasury Regulations or by the IRS,
leaving the door open for an IRS agent to claim that a person who, say has a
U.S. bank account or owns real estate in the U.S., has an abode in the U.S. (and
therefore cannot have a foreign tax home and not qualified to claim the FEIE),
and the way income tax matters work, the burden of proof is on the Taxpayer to
prove that the IRS is wrong and that he or she is right. It is interesting to
note that during the initial examination the examining agent refused to consider
Mr. X's discussions of the IRS position as described in Publication 54, stating
that he could only go by what was in the Code or the Regulations, although was
incapable of discussing the legislative intent of Code Section 911 or for that
matter explaining why he felt that Mr. X did not meet the qualifications of
Section 911 other than state that Mr. X had an abode in the U.S. without fully
explaining why he believed that to be true.

Upon completion of the examination of the 2006 and
2007 income tax returns, as Mr. X disagreed with the findings and proposed
adjustments, the case was referred to Administrative Appeals. Although the
initial office examination was conducted out of Los Angeles, as Mr. X now
resides in Virginia, the appeal was assigned to the IRS center in Richmond, VA.
Although at first it seemed that as Mr. X was insistent that he could not
concede to the audit examination findings and adjustment, the Appeals Officer at
first seemed prepared to allow Mr. X to take the matter to Tax Court. However,
once Mr. X expressed his willingness to take the case to the Courts, the Appeals
Officer began to have second thoughts, even mentioning that the Government may
not have a strong enough case to win, and it was in the Government's best
interest to settle the examination at the appeals level. Now here is where this
becomes really interesting, but to fully appreciate this I need to share some
background with the reader.

Mr. X was hired in July of 2006 as an independent
contractor to work for Blackwater in Iraq in support of the U.S. military, where
he worked in Bagdad through the end of 2007. When he left the U.S. he did not
turn in his U.S. driver's license or close his bank account, however being
single he made no trips to the U.S. in 2006 since beginning his Bagdad
assignment and in 2007 only spent 33 days in the U.S. during the entire year.
Given that his assignment lasted for more than 12 months, and was intended to be
as such, Mr. X's tax home (by definition) was his primary place of employment,
which was Iraq. Although the Code states that if a person maintains an abode in
the U.S., that person cannot have a tax home abroad, the concept of abode is
nowhere clearly defined and even the Treasury Department states that the
determination of if the person maintains an abode in the U.S. is based on all
facts and circumstances. Prior to leaving the U.S. for Iraq Mr. X did not even
own a house in the U.S., although anticipating that he would eventually return
to the States, he took advantage of the depressed housing market to purchase a
home in the U.S. in 2007, where he permitted his mother to live only for a few
brief months. This also should not be considered as his abode as, amongst other
factors, he never lived there. So we have the two qualification tests met for
Mr. X to qualify for the IRC Section 911 FEIE, his tax home was outside the U.S.
and during both 2006 and 2007 there existed two consecutive 365 day
periods during which Mr. X was outside the U.S. for more than 330 days.
Accordingly the taxpayer should be qualified for not only the maximum FEIE as
calculated based on the number of days in the qualifying period of each year,
but also a foreign housing deduction for this period as well, also determined
pursuant to IRC Section 911. One twist, however, is that the CPA who prepared
the 2007 income tax return took a $40,000 deduction for meals and lodging,
without increasing income for the value of meals and lodging provided by
Blackwater (based on the per diem allowance) which was incorrect as Mr. X
considered his tax home as being in Bagdad and therefore was not entitled to
deduct expenses for temporary living expenses. What should have been done is to
include the value of meals and the camper assigned to Mr. X in Mr. X's gross
income, and then taking a deduction for the Section 911 foreign housing
deduction.

Here is what I believe should have been done at
the agent examination and later the appeals level. Mr. X should have been
required to include the value of meals and lodging provided by Blackwater in his
gross income. First of all, as Mr. X had served in the U.S. military in Iraq as
a young man prior to working for Blackwater had had already established ties
with the local culture in Iraq, both military and civilian. Then after returning
to the U.S. for approximately 6 months, he was assigned to Bagdad for and
additional 18 months with Blackwater, was single and had no spouse and children
living in the U.S., only visited the U.S. for 32 days during the 18 months, and
did not own vacant residential real estate in the U.S. that he used for
extensive stays in the U.S. during his overseas assignment (in fact he never
lived there and it was purchased as an investment while his tax home was in
Iraq-although he did permit his mother to live there for three months while he
was in Iraq), I can't think of any reason, based on my understanding of the
Congressional reports, legislative intent, Treasury Regulations or IRS Revenue
Rulings, etc. that causes Mr. X as NOT qualifying for the IRC Section 911
foreign earned income exclusion or the excess housing deduction. Given his
situation in Bagdad, it was totally unrealistic for him to even consider having
a bank account there or purchasing property, and given the facts and
circumstances, at his age and spending so long a time in Iraq, how is it
feasible to argue that his abode was in the U.S. At that age and given his
situation, he may have moved to Italy after his assignment ended. He then should
have been permitted a deduction from gross income on Line 26 of Form 1040 for
the maximum allowed Section 911 FEIE and housing deduction as computed on Form
2555. He then should have been assessed additional tax based on the imputed
value of meals provided by Blackwater and paid statutory interest on this
amount. Penalties for accuracy and understatement of tax liability should have
been abated as the taxpayer relied on the advise of his tax return preparer and
should know the tax laws (and possibly assessed against the tax preparer). This
is what should have been done.

However this is where it stands now, and may
ultimately go to Tax Court and most likely be a landmark decision in favor
of both Mr. X as well as all American Expatiates in his situation. Although the
IRS should continue to pursue those taxpayers who abuse the law and file tax
returns erroneously claiming the benefits of Section 911, it is hoped that the
Court determine a clear definition of exactly what constitutes a U.S. abode for
purposes of determining if a U.S. person has a foreign tax home, and prevent the
IRS from making arbitrary and capricious assessments based on an American having
an abode in the U.S. where there is no clear definition of exactly what
constitutes an abode.

It is interesting what transpired at the
administrative appeals level once the officer decided it was contrary to the
Government's best interests not to have this matter be litigated. First there
was no question that the value of meals and lodging had to be imputed into gross
income. Mr. X is an independent contractor and received this benefit as part of
his compensation. However the appeals officer agreed to allow the foreign
housing deduction pursuant to Section 911 for the value of the lodging. By doing
this she acquiesced that Mr. X's tax home was outside the United States, which
was the examining agent's primary argument for disallowing the Section 911
exclusion. However, as regards the Section 911 foreign earned income allowance,
the appeals officer arbitrarily proposed only allowing 80% of the calculated
FEIE for 2006 and 40% for 2007. After Mr. X argued that if he is deemed to have
a foreign tax home for purposes of the Section 911 foreign housing deduction,
why then should he agree to an arbitrary disallowance of a portion of the FEIE
for 2006 and 2007, for which he should receive the entire amount permitted
pursuant to Section 911 of the Code. Either a taxpayer qualifies or not. The
appeals officer then agreed to allow 100% of the calculated FEIE for 2006 but
only 70% for 2007. Again, either one qualifies or they do not, and if the
taxpayer qualifies pursuant to the provisions of the code, they are entitled to
exclude an amount as determined by the Code.

At this time Mr. X is scheduled for one additional
meeting with the appeals officer before deciding to litigate this in Tax Court.
If the IRS concedes that Mr. X did in fact have a foreign tax home and is
entitled to the full FEIE exclusion as determined by the Code, the definition of
abode will remain ambiguous and it will be left to another taxpayer to argue the
matter once an agent from one of these five special project groups takes the
position that any slight connection with the U.S., such as a drivers license or
a bank account, constitutes having an abode in the U.S., using that to claim
that a taxpayer does not have a foreign tax home and deny the benefits of the
Section 911 FEIE. On the other hand, should the IRS insist on their arbitrary
and unprofessional approach, Mr. X is prepared to litigate this in Tax Court,
whereby we may finally get a clear definition of a "U.S. abode" that can be used
as precedence.

Stay tuned for future updates. In the meantime, I
will be looking over the tax returns as filed by Mr. X, the audit examination
report and other correspondence relating to the audit and the audit appeals.

In closing this report I would also like to share
with you something that Mr. X said to me. He is curious as to why the Service,
under the direction of our existing Administration, is so focused on auditing
tax returns of workers who are willing to endure the hardships of living under
such hazardous conditions in support of U.S. soldiers and our national
commitment to stabilizing conditions in Iraq and Afghanistan as well as the
global war on terror. He also pointed out that the IRS employee who conducted
the original examination of his tax return at first stated that he was not
entitled to the Section 911 foreign earned income exclusion because he was
a government employee, which he changed once he realized that Mr. X was a
subcontractor of a government contractor. The point being that if the U.S.,
since ending the draft in 1973, has an all volunteer army, and these soldiers
are entitled to tax exempt treatment of their U.S. government compensation, why
then do not employees of government contractors (or subcontractors of U.S.
military contractors) who are doing the same job under the same conditions, not
also permitted the same tax treatment, and in fact are being targeted as a
possible means of "closing the international tax gap" in order to raise money to
offset government deficit spending. I am not sure that I disagree with his
logic; however this is certainly something that should be considered by Congress
as they debate upcoming tax reform.

One additional fact that has just been learned.
According to the taxpayer, when he asked the AO why she felt that he had an
abode in the U.S. even though he had left home when he was 19 to serve his
country in the military, and then went to work for Blackwater where he lived in
Iraq for over 18 months, returning to the U.S. for only 33 days during that
time, her response was that he purchased a house in the U.S. that was used for a
brief time by his mother, as well as keeping his bank account open and his
driver's license valid, EVEN THOUGH HE DID NOT USE THE HOUSE AS HIS PLACE OF
ABODE DURING THE TIME HE WORKED IN IRAQ. Now remember that the statutory
language is "if the taxpayer's abode is in the U.S.", not if the taxpayer owned
a house that could be used as an abode. It is on this basis that the taxpayer
will base his case before the Tax Court.